Evaluating Software as a Service (SaaS) Companies 

With the rapid rise and adoption of the internet in the 90s, a new business model for software companies also came into play; Software-as-a-Service (SaaS). A SaaS model is one where the product or service is delivered, via a web application, to its customers in exchange for a monthly or yearly subscription. Salesforce is one of the first companies that was a pure SaaS play providing a customer relationship management platform, and has experienced incredible growth and success. Many companies have transitioned to or adopted this model as it serves a sustainable, scalable and successful way to grow the company and predict its future performance. 

A multitude of new financial and operational metrics spawned off of this new model to measure a company's performance. Today, the SaaS model has been widely adopted across many areas such as collaboration, communication, human resource management, business intelligence, customer support etc. Almost every software startup today is a saas company. Evaluating an early stage saas company with traditional methods (P/E, Discounted Cash flow, Dividend discount model) are of less use, sometimes impossible, because of the company's limiting financial history and operating losses. It is important to quantify the business in terms of how fast it is growing, what's driving its growth, how efficiently it is using the capital it raised, customer satisfaction, and revenue expansion efficiency. Understanding these aspects of the company gives you a better view of the overall business and its path to profitability, may it be a long one.

Churn, Conversion rate, and LTV

When it comes to measuring customer happiness, the most important metric is churn. (Logo) Churn is the percentage of customers that cancel their subscriptions over a period of time, usually monthly. Keeping this number low is beneficial. This metric also tells us if the company is targeting the right segment of customers, especially in B2B (hitting the right segment ensures low churn). Along with this metric, the conversion rate measures the rate at which leads turn into free trials, or free trials turning into customers. That would measure the effectiveness of landing pages and price points.  

Derived from the churn rate is the Customer Lifetime Value (LTV). This is a measure of how much money is generated from a customer during its engagement with the company. It is calculated as (1/churn)*ARPU where ARPU is average revenue per user. This metric by itself is not that useful but when combined with CAC, it tells us about the efficiency of capital being deployed. 

Customer Acquisition Cost

CAC - A summation of all marketing and sales expenses over a period of time, divided by the number of new customers onboarded during that period of time, usually monthly. This tells us the dollar amount spent to acquire a new customer. Dividing the LTV by the CAC tells us about the efficiency of operating expenses; CAC-to-LTV. An ideal value for this ratio is 3-4. If lower, means you're spending too much, and if higher, it would mean you're probably missing out on lost business.

Revenue metrics

For early stage companies, it is important to note the monthly recurring revenue MRR, and how fast the MRR is growing. This growth is in direct correlation with the company's growth. If a company has a wide range of subscription plans depending on the size of the customer, it would be useful to look at revenue churn instead of logo churn. 

For more established SaaS companies, it is useful to look at Net Revenue Retention. It is calculated by dividing current MRR from a group of customers by the MRR of the same group of customers a year ago. This tells use how the business is retaining existing customers and expanding revenues from them by up selling and adding more products and features.

Qualitative factors

Depending on the size of the company, certain qualitative measures become important. Due to the very nature of being a software company, there are usually hidden intangible assets that could widen the company's moat, or sustainable competitive advantage. 

With small sized companies(annual revenue less than $1m), it is important to look at the founder's track record. Are they serial entrepreneurs? Do they have experience in their domain? How has their past experience led them to where they are now? Do their skills complement each other? Is the team focused more on engineering or sales/marketing? Do they have any patented IP?

With larger companies, one of the most valuable intangible asset is synergies across products. Having many products that work in tandem with each other is a huge plus. The synergies could be driven from acquisitions or in house development.

Another important factor is the investors and board of directors. Being backed by investors who have experience in the space can help a ton. They provide valuable connections and can generate strategic partnerships.

Conclusion

SaaS companies have exponentially grown in number, and are here to stay. As the space gets more and more crowded, there are some trends that separate the successful companies from the failures. The successful ones, usually start off with a niche product, gain customer loyalty, and then expand into a suite of products and tools. Along with offering more products, there has been a trend of moving from SaaS to PaaS/IaaS (Platform as a service, Infrastructure as a service). After reaching a certain size, the company shifts its focus from acquiring new customers to retaining existing ones and expanding revenues from them. How do they do it? by providing a platform to allow customers to create add-ons for their original products. Popular examples are Amazon's AWS Beanstalk and Salesforce's Force.com. Along with that, companies also started to unbundle their products into API's, which allow their customer to use those services in a more flexible way. 

SaaS models are constantly being applied to a wide category of industries and fundamentally changing the way companies operate. The future of saas is bright and shows no signs of slowing down.